With economy weak, Fed delays move to withdraw stimulus

(MoneyWatch) Federal Reserve officials held off Wednesday in starting to wind down the central bank's $85-billion-a-month bond purchase program, a sign they think the economy remains too weak to begin withdrawing stimulus.

Many economists and stock analysts had expected the Fed to announce plans to trim its monthly purchases of Treasury and mortgage bonds. But weak job gains in recent months, coupled with subpar economic growth in the first half of the year, appear to have weighed on members of the Federal Open Market Committee, the bank's monetary policy panel.

Stocks surged after the FOMC issued its policy statement, with the S&P 500 and Dow Jones industrial average both ending the day at all-time highs. The Dow climbed 146 points, or 0.9 percent, to close at 15,675. The S&P gained 221 points to finish at 1,725. The Nasdaq composite finished at 3,784, up 38 points. Gold and oil also spiked. Interest rates plunged.

"This is a surprise -- everyone was expecting some kind of tapering," said Boston College economist Peter Ireland. "What the Fed said today is, 'We just want to wait a little while to see whether the apparent strength of the economy really is there or whether there is still enough fragility to demand caution.' "

Wrapping up a two-day meeting, the FOMC said the economy is growing at a moderate pace. But the panel said it wants "more evidence that progress will be sustained" before adjusting the pace of its bond purchases. "Accordingly, the committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month," the panel said in a statement.

"The implication is that tapering will probably start soon, but they are not ready to make the move yet," noted Jim O'Sullivan, chief U.S. economist with High Frequency Economics.

The Fed trimmed its forecasts for economic growth this year and in 2014. It now expects GDP this year of 2 percent to 2.3 percent, down from a June projection of 2.3 percent to 2.6 percent. Growth is predicted to range from 3 percent to 3.5 percent next year. The bank forecasts unemployment to end 2013 at 7.1 percent to 7.3 percent, before declining to 6.5 percent to 6.8 percent in 2014.

Some economists said the decision to delay tapering the bond purchases was understandable given the anemic economic growth. But they criticized Fed chief Ben Bernanke and other Fed policy makers for a lack of clarity in their intentions for monetary policy.

"Mr. Bernanke and his colleagues will doubtless point to the caveats, ifs and buts sprinkled throughout their public communications, but this is as clear a case of jilting at the altar as you are ever likely to see," said Ian Shepherdson, chief economist with Pantheon Macroeconomics, in a research note.

In a press conference to discuss the FOMC's statement, Bernanke defended the Fed's move this summer to broadcast its plans to scale back the bond purchases.

"Failing to communicate that information would have risked creating a large divergence between market expectations, public expectations and the committee's intentions, and that could have led to much more serious problems down the road," he said.

Although setting monetary policy is always a guessing game, with the Fed tuning interest rates and taking other measures based on myriad forecasts about where the economy is headed, central bankers faced an especially delicate balancing act this time around. Moving too soon to withdraw stimulus by tapering bond purchases could slow the recovery, or even throw it in reverse. The purchases are aimed at keeping a lid on long-term loan rates and to boost borrowing and spending.

For instance, interest rates on home loans have risen since the bank signaled this spring that it planned to start scaling back "quantitative easing," as the bond purchases are called. The Fed's pronouncements have also sent borrowing costs rising overseas, making it more expensive for businesses to expand. Weaker global growth hurts the U.S. economy.

Yet waiting too long to begin weaning the financial system off the easy money the Fed has pumped into the economy over the last five years risks setting off spiraling inflation. For now, the bank faces the opposite problem -- persistent slack in the economy means prices are growing too slowly, which harms businesses and can discourage hiring. Inflation continues to undershoot the 2 percent target the Fed considers healthy.

The Fed must juggle these goals against its usual, if unofficial, task of managing investor expectations. In May, stocks plunged more than 500 points in the two days after Bernanke discussed the bank's tapering plans.

A key gauge of the market's response to the Fed's announcement are interest rates on bonds, whose movements indicate investors expectations' for the economy and for monetary policy. Since Bernanke first began telling the country that the Fed was planning on scaling back on its bond purchases, bond prices began to fall, sending interest rates on the bellwether 10-year Treasury bond from around 1.6 percent to about 2.9 percent.

Beyond the Fed's immediate plans for dialing back bond purchases, financial markets will study the bank's longer range growth forecasts for clues on when it might start tightening interest rates. The Fed has sought to tamp down fears about the impact of ending quantitative easing by emphasizing that it does not expect to raise interest rates any time soon.

FOMC members do not expect the first hike in the benchmark federal funds rate, or what banks charge each other for short-term loans, until 2015. The federal funds target will be 2 percent by the end of 2016, according to the panel's forecast. That is 2 percent higher than what the Fed considers appropriate in an economy running at full capacity.

By contrast, one thing is certain about the economy: Progress has come slower this year than the Fed expected, and today's decision reinforces that reality. The pace of job-creation has weakened in recent months, with the unemployment rate ticking down only because many have left the labor force. GDP, the total value of all goods and services, grew a meager 1.8 percent in the first half of 2013, held back by big cuts in government spending and higher taxes. Most economists expect growth of no more than 2 percent.

For virtually all Americans, meanwhile, pay remains stagnant, while 1 in 7 people are in poverty, according to U.S. Census Bureau data released this week. For all but the wealthiest 5 percent of Americans, income remains lower than before the recession that followed the 2008 financial crisis.

  • Alain Sherter On Twitter»

    Alain Sherter is an award-winning business journalist who has written for The Deal, MarketWatch and Thomson Financial Media.

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